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Income Tax Effects of Foreclosure & Other Relief of Debt

General Rule. If you negotiate a workout with a lender (including a short sale) where you are relieved of some of your debt, you will be issued an IRS 1099-C. You will have taxable income on which you must pay income tax unless you are insolvent or in bankruptcy. This can be a very big bite which could take years to pay. Don’t make the mistake of getting a forgiveness of debt if you may have to take bankruptcy later. Because you cannot later discharge this tax debt in bankruptcy. You would have no tax debt if you had taken bankruptcy first.

A big problem with the forgiveness of debt which you get in a workout such as a short sale or a deed in lieu of foreclosure is that the forgiveness of debt is taxable income in the year of the forgiveness. You must pay tax just as if you had earned that amount of money.

This means that now you have another debt to pay, except that the new tax debt cannot be discharged in a later bankruptcy until it is more than 3 years old and you have not made an agreement with the IRS to "toll" the running of the 3 years.

This also applies to other debt reduction agreements, even credit card debt forgiveness.

The lender is required by law to issue an IRS 1099-C to you for the amount of debt which is forgiven. You must pay income tax on this amount unless you either are insolvent at the time of the debt forgiveness or you obtain the debt forgiveness after you file bankruptcy.

However, to claim insolvency, you must also consider your exempt assets, such as retirement assets. Your exempt assets may prevent you from claiming insolvency.

The best solution for you is to discharge the debt in bankruptcy. Then you pay no income tax.

Example of Income Tax on Debt Forgiveness; Short Sale (or Deed in Lieu): Foreclosure; Other Bills

 Mortgage Balance: $190,000

You have a buyer who is willing to pay $160,000. If the lender agrees to this short sale, then you will have taxable income of $30,000 because the lender has forgiven $30,000 of your debt.

You must pay income tax as though you earned the $30,000. Your will receive an IRS Form 1099-C. This is bad news. You must work to avoid this income tax.

If you were insolvent to the extent of $5,000, then your taxable income would be reduced to $25,000. Exempt assets are considered in the insolvency calculation.

However, if you get rid of the debt in a bankruptcy filing, then you have $0 taxable income.

A big trap to avoid is the discharge of debt prior to filing bankruptcy. Then your income tax obligation cannot be reduced or eliminated. This would be a big mistake because you did not do proper planning. Instead, discharge your debt in bankruptcy.

This example is the same for any other forgiveness of debt. Such as credit cards, 2nd mortgages, car loans, and medical bills.

This example may apply to you whether you end up in foreclosure, do a short sale, give a deed in lieu of foreclosure, or any other circumstance where you are relieved of debt.

Your lender does not want you to know this, so that you will do what the lender (or bill collector) wants you to do.


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